Years ago, I found myself sitting in law school in Moot Court wearing an oversized itchy blue suit. It was a horrible experience. In a desperate attempt to avoid anything like that in the future I enrolled in a tax course. I loved it. I signed up for another. Before I knew it, in addition to my JD, I had a LL.M Taxation. I needed only to don my cape…. taxgirl® was born. Today, I live and work in Philadelphia, PA, one of the best cities in the world (I can't even complain about the sports teams these days). I landed in the City of Brotherly Love by way of Temple University School of Law. While at law school, I interned at the estates attorney division of the IRS. At IRS, I participated in the review and audit of federal estate tax returns. I even took the lead on a successful audit. At audit, opposing counsel read my report, looked at his file and said, “Gentlemen, she’s exactly right.” I nearly fainted. It was a short jump from there to practicing, teaching, writing and breathing tax.

Deduct This: The History of the Medical Expenses Deduction

When you ask most taxpayers about available tax deductions, the deduction for medical expenses immediately springs to mind. It’s probably one of the most talked about deductions (in fact, a fairly significant portion of the questions submitted to the blog by taxpayers focus on the medical expenses) but the reality is that very few taxpayers actually claim the deduction on their tax returns.

Even if your itemized deductions are less than the standard deduction, you may choose to itemize deductions. This isn’t very common but it may make sense because of your state tax return or because you are married filing separately and your spouse chooses to itemize. Whatever the reason for opting in, itemized deductions are still only claimed by about a third of all taxpayers. For 2010, that works out to about 48 million taxpayers.

Of those taxpayers who choose to itemize, most do not claim medical expenses as deductions on their Schedule A. In fact, for the latest years that the IRS has made the data available, medical expenses were not the most popular Schedule A deduction – that would be taxes paid. They also were not the second, third or fourth most popular – those would be charitable deductions, home mortgage interest and miscellaneous deductions subject to the 2% floor, respectively. According to the IRS, a mere 17% of taxpayers who itemized deductions in 2001 claimed medical expenses (report downloads as a pdf). If you do the quick math, that works out to about 6% of all taxpayers. It’s a rather unimpressive number.

Of course, it’s not hard to understand why this happens when you look at the demographics and the restrictions. Most itemizers tend to be middle to upper income taxpayers since to hit the standard deduction limits requires generally – though not always – a certain level of income to support those expenses. And even though this is changing, traditionally, middle to income wage earners tended to have their medical insurance provided by an employer. The cost of medical insurance is generally the expense that puts taxpayers over the magical threshold to claim the medical deduction.

That magical threshold varies from taxpayer to taxpayer since qualifying medical expenses are only deductible to the extent that they exceed 7.5% of your adjusted gross income (AGI). So for example, if your medical expenses total $5,000 and your AGI is $50,000, you can deduct $1,250 of medical expenses: $5,000 (total expenses) less $3,750 (7.5% of $50,000). This formula sets the bar pretty high. However, when you factor in the average cost of health insurance, which was $13,375 per family in 2009, you can see that the threshold is much easier to meet if you’re paying for insurance.

Even though the income tax had been around since the turn of the 20th century, no deduction was allowed for medical expenses until the United States Revenue Act of 1942 was signed into law by President Franklin Delano Roosevelt who called the bill “the greatest tax bill in American history.” The deduction was first applicable to those medical expenses which were “extraordinary” (whatever that meant) and limited to those expenses which exceeded 5% of AGI subject to a cap. It appears, from the legislative history, that it was intended for the deduction to be a temporary form of relief during wartime:

This allowance is recommended in consideration of the heavy tax burden that must be borne by individuals during the existing emergency and of the desirability of maintaining the present high level of public health and morale.

The medical deduction turned out not to be temporary at all and was further tweaked in 1944 and then significantly changed in 1954, perhaps not coincidentally during another war. A feeling of permanence settled in when the medical expense deduction was given a new code section, moving it to section 213, where it remains to this day, though realistically that probably had more to do with efforts in 1954 to consolidate the existing provisions of the 1939 to 1953 Tax Codes.

As part of the 1954 changes, the threshold for claiming expenses was lowered to 3% and the cap on the expenses was doubled. Ten years later, the ceiling on medical expenses was eliminated though the floor remained.

In 1982, as part of the Tax Equity and Fiscal Responsibility Act (“TEFRA”), the first of then President Ronald Reagan’s tax bills, the floor for the medical expense deduction was increased (again) to 5% of AGI. Confusing limits on prescription drug expenses were also eliminated beginning in 1984. Additionally, under TEFRA, nonprescription drugs were ineligible expenses for purposes of the deduction.

The Tax Reform Act of 1986 made sweeping changes to the Tax Code but had little overall impact on the medical deduction, relatively speaking. The floor was raised a couple of percentage points to 7.5% of AGI, where it is today.

Since 1986, Congress hasn’t fiddled with floors, ceilings and other limitations when it comes to medical expenses. Rather, the focus has been on what constitutes medical expenses for purposes of the deduction. Medical expenses are no longer required to be “extraordinary” – just medical expenses paid:

“for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body”

While some clarification has come out of case law, such as, for example, a ruling that transgender surgery may be deductible and IRS guidance such as the private letter ruling indicating that infant formula would not be treated as a medical expense, Congress has made some effort to clarify which expenses might be deductible. The cost of getting to and from medical care, including transit and parking, has been confirmed at section 213 as deductible. Medical insurance premiums have generally been deductible (some exceptions applied in 1942) but questions remained about other kinds of insurance. In 1996, under the Health Insurance Portability and Accountability Act (“HIPAA”), Congress confirmed that expenses for qualified long-term care services are treated as medical expenses, including insurance, with limits.

Moving forward, it’s hard to say how the new health care plan is going to change the popularity of the medical expenses deduction in terms of the sheer numbers of taxpayers who will pay for health care. What is clear is that the threshold will be more difficult to meet. Beginning in 2013, assuming that nothing changes, the floor for itemizing medical expenses will be increased from 7.5% of AGI to 10% of AGI. Seniors are exempt from the increase through January 2017.

It would appear, from the history, that Congress can’t seem to get a handle on the medical expense deduction. The floor is confusing for taxpayers and has varied wildly – up and down – for nearly seventy years. There are no such floors for other, more popular deductions, such as taxes paid and home mortgage interest. Is that because bankers have better lobbyists? Or do we just value homes over health care generally?

And while medical expenses are increasing, statistically, those taxpayers who could benefit most from the deduction tend to be barred from taking it either because they don’t itemize or their expenses are too limited by their AGI. With the proposed increase in the floor, which was classed as a revenue raiser, the pool of taxpayers eligible for the deduction will continue to shrink. Considering all of the efforts to tweak the law and then tweak it again, you have to wonder about the value of the medical expense deduction: is time for it to go?

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This is Part Two of my series on the history and evolution of popular tax deductions; you can read the first of the series here. The series will continue throughout the month of June. To celebrate – cause I’m that much of a tax geek – I’m hosting a giveaway. You can enter to win a Kindle by letting me know your favorite tax deduction – details can be found here.

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